How positive thinking kicked off Japan’s boom

Deflation has come up indirectly in almost every piece I’ve written about Japan over the past two months. When I wrote about stock valuations, central bank credibility, corporate governance, and the biggest consequences of Abenomics, deflation was always there. Lurking in the background.

The following three obscure headlines are good news if you’re planning to invest in Japan…

  • Kirin pursues $932 million buyback as it continues Asian expansion…
    – The Japan Times
  • Japanese Companies Are Rushing to Sell Longer Dated Bonds…
    – Bloomberg
  •  NTT to Buy Back Up to $1.4 Billion in Shares to Help Returns…
    – Bloomberg

What’s so good about them? It’s to do with deflation.

Deflation has come up indirectly in almost every piece I’ve written about Japan over the past two months. When I wrote about stock valuations, central bank credibility, corporate governance, and the biggest consequences of Abenomics, deflation was always there. Lurking in the background.

I never stopped to explain it fully because it’s a big topic. But today’s the day.

The definition of deflation

Deflation is where consumer prices go down over time instead of up. Japan’s had a bad case of the deflations since 1990.

Now you might think falling consumer prices are a good thing, and of course they are in a way.

The problem is that deflation often means incomes fall as well as prices. Wages and consumer prices are two sides of the same coin.

In Japan since 1990, even though consumer prices have been falling, wages have been falling (or at least failing to rise). The result has been a long gradual decline in Japanese living standards relative to other rich countries.

It’s a peculiar problem. Japan is the first country in economic history to suffer from it.

So what causes deflation? And how is Shinzo Abe going about fixing it?

The tank at the end of the garden

To understand deflation you need to think in terms of the supply and demand for money.

The supply of money is relatively easy to get your head around. This is just the total quantity of pounds, dollars, yen or whatever. Central banks control the supply of money (commercial banks play a part too, but central banks run the show).

Demand for money is weirder. It seems like a contradiction in terms. How could there be said to be demand for money? Isn’t demand for money infinite?

Economists mean something specific when they talk about the demand for money: they’re talking about demand for cash at hand. Money you have, but don’t spend. Your money inventory.

I’m going to borrow the economist George Selgin’s analogy: demand for money is like demand for home heating oil. When I was growing up we didn’t have a central gas connection, so we relied on a tank of heating oil in the back garden which was refilled a couple of times per year. When the weather was particularly cold we made sure we had plenty of oil. Other times it didn’t seem necessary.

That’s like the demand for money. All of us keep a certain amount of money in our current accounts, or even under the mattress. That’s our money inventory. And like heating oil, our demand for money changes depending on our circumstances. When times are dicey and uncertain we hoard money — just in case. When times are good, we spend it or invest it.

So demand for money is demand for money we don’t spend. The way we demand it is by holding it rather than spending it.

Now think about central bank policy. Central banks heat up the economy by printing more money and they cool it down by taking money out of circulation. By changing the supply of money, in other words.

But of course the story doesn’t end there. The demand for money matters just as much as the supply of it. If people start hoarding money all of a sudden, because they’re worried about the future — if demand for money goes up, in other words — that will have the same effect on the economy as reducing the supply of money. It’ll slow down the economy, and cause prices to start falling. Deflation.

Conversely, if people feel good and start spending money willy-nilly, running down their cash reserves — i.e. if the demand for money goes down — that will have the same effect as the central bank printing more money, i.e. increasing the money supply.

You can’t understand central banking, or Japan, or indeed much about the economy, without understanding how supply and demand for money fit together. If you only think about supply or demand in isolation, you’ll miss what’s really going on.

Breaking the mindset

So since 1990 Japan has been stuck in a low gear. Prices have been falling and the economy has been slow.

Can you now see what’s been going on?

Since 1990 the Japanese economy has been slow, so people have been worried about the future. This has led them to hoard money, rather than spend it. Which has ensured the economy stays weak. It’s a self-fulfilling prophecy.

It applies to companies as much as individuals. If companies don’t see money-making opportunities, they’ll be less inclined to invest in new machinery or buy other companies. I mentioned this in my piece about company valuations  two weeks ago: “Hoarding cash is a habit Japanese companies picked up in the late 1990s and 2000s. In 1998 companies’ cash piles were about a quarter of Japan’s GDP, whereas today they’re nearly 70% of it.”

Fixing the problem means fixing the mindset. Japanese consumers and businesses have to stop hoarding cash.

How do you stop people from hoarding cash? You do what the Bank of Japan has been doing. You print loads of money. You convince people and companies that their cash hoards are going to be worth less next year than they are this year.

As I wrote in How the Bank of Japan Learned to Toughen Up , that’s “why the Bank of Japan has had to print an outrageous amount of yen month-in month-out for four and a half years. It’s had to stick to its promise until people take it seriously.”

Once people start to believe in this idea — the idea inflation is coming — it creates another self-fulfilling prophecy. People consume more and they invest more.

And that’s basically what’s been happening in Japan. That’s why employment is up, wages are up, investment is up, stocks are up, and deflation is on its way out.

So what’s so special about the headlines I showed you at the beginning of the piece? Two of those stories, which are less than a week old, are about Japanese companies deciding to hoard less money by buying back shares.

The other story is about Japanese companies borrowing long-term. That’s a good trend because companies don’t borrow cash in order to hoard it; they borrow to spend it. The fact that they’re doing it signals a) they see investment opportunities now, and b) that they think inflation is coming, which will erode their debt.

All good news. The negative cycle is turning into a positive one. And the pickings are rich for stock market investors.

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